CORPORATE REHABILITATION ACT (CRA)

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CORPORATE REHABILITATION ACT (CRA) BACKGROUND,
CONCEPTS AND LEGAL ARCHITECTURE
Salman Ali Shaikh January 2009
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INSOLVENCY SYSTEMS AND RISK MANAGEMENT
CONCEPTUAL ISSUES

• The creation of an effective insolvency regime is
  a successful interplay of three key elements
  design, legislation and implementation.
• The government needs to understand that it is the
  ultimate risk manager (David Ross Harvard
  Business School).
• The development of a modern insolvency system
  gives the government the ability to manage risk
  by reducing and/ or allocating risk to different
  segments of the market and society. The CRA gives
  the GoP a very powerful tool in terms of economic
  policy.
• The creation of a transparent system with
  predictable outcomes greatly enhances long-term
  capital formation and promotes FDI (e.g., China).

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INSOLVENCY SYSTEMS AND RISK MANAGEMENT
CONCEPTUAL ISSUES (Contd)

• Universal best practices (e.g., UNICTRAL
  Legislative Guide on Insolvency Law) are never
  best everywhere they are best only in
  specifiable circumstances. However, they do
  provide a very useful road map.
• Due consideration needs to be given to the
  structure (present and desired) of the national
  economy, legal and cultural impediments, etc.
• Economic cycle issues i.e., when the
  liquidation values of companies are greater than
  the going-concern value, you do not need an
  insolvency system. You merely need to tighten
  your recovery laws, systems and procedures.
• The need for a corporate rehabilitation law in
  Pakistan. Urgently needed because corporate debt
  has been growing (at 10 - 12 p.a.) and
  liquidation values have been declining at the
  same rate for the past several years.

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INSOLVENCY SYSTEMS AND RISK MANAGEMENT
CONCEPTUAL ISSUES (Contd)

• The compound effect of these two simultaneous
  processes does not need a graph to visualize. The
  liquidity gap (going-concern basis) doubles every
  6-7 years.
• 3 key elements re-stated design, legislation and
  implementation. Two elements (design
  implementation) have been lacking in all the
  legal enactments since 1997.
• The proposed CRA is an attempt to correct all
  imbalances created by these enactments.
• The fourth key element in insolvency is time. In
  insolvency the consequences of a few mistakes
  (errors of judgement) are minor compared to the
  costs of delay.
• Therefore, a significant part of this
  presentation will focus on the design (i.e. the
  legal architecture) of the proposed CRA.

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INSOLVENCY SYSTEMS AND RISK MANAGEMENT
CONCEPTUAL ISSUES (Contd)

• Enacting a law is relatively easy. Making it work
  (i.e., implementation) is often very difficult.
• Political will is crucial. Specialized laws need
  a state-of-the-art enabling environment to
  deliver results. Capacity-building and
  institution-strengthening.
• During the designing process we had to ask
  ourselves three very basic questions.
• Where are we??
• Where do we want to be??
• How do we get there??
• Basically the desired outcome(s) should determine
  the design of the law.
• The function must determine the form (Walter
  Gropius Bauhaus school of architecture).

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GROUND ZERO WHERE ARE WE???

• Since 1997, there have been random mood swings on
  a national basis between the desire for
  recovery (of bank debt) and the aspiration to
  revive (sick industry).
• However, in terms of legislation, recovery
  became an obsession.
• The (essential) balance between debtors and
  creditors rights were sacrificed for this cause.
• The CRA has been designed to achieve both
  objectives while maintaining a balance between
  debtors and creditors rights.
• Successive waves of creditor-friendly laws were
  enacted e.g., the Recovery Act 1997, NAB
  Ordinance 1999, CIRC Act 2000 and the Recovery
  Act 2001.
• Inspite of this onslaught, NPL continued to
  remain at high levels.

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GROUND ZERO WHERE ARE WE??? (Contd)
Non-Performing Loans (NPLs) of the Banking
System (Rs. in Billion i.e., in Column 2).
Year NPLs NPLs to Loans Provisions to NPLs

1997 173.0 23.5 46.6
1998 183.0 23.1 58.6
1999 230.7 25.9 48.6
2000 240.1 23.5 55.0
2001 244.1 23.4 54.7
2002 231.5 21.8 60.6
2003 211.3 17.0 63.9
2004 199.7 11.6 70.4
2005 177.4 8.3 76.7
2006 175.5 6.9 77.8
2007(Provisional) 205.7 7.5 79.2
Source State Bank of Pakistan Source State Bank of Pakistan Source State Bank of Pakistan Source State Bank of Pakistan

• NOTE There are concerns about data integrity
  owing to conceptual and methodology related
  issues e.g., two regulators, NPL at CIRC,
  facility-based classification, accounting
  implications of Recovery Act 1997/ Recovery Act
  2001, etc. While the figures of NPL in the
  banking sector are probably reliable, the overall
  figures for the financial sector are
  significantly higher, and are not quantified (at
  present).

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GROUND ZERO WHERE ARE WE??? (Contd)
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GROUND ZERO WHERE ARE WE??? (Contd)
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GROUND ZERO WHERE ARE WE??? (Contd)

• In 2002, in recognition of the failure of CIRC,
  NAB and CIRSU to make a significant contribution
  on the NPL front an administrative (i.e., an
  amnesty scheme) insolvency solution was resorted
  to.
• The SBP issued guidelines (effectively a
  directive) whereby banks were actively
  encouraged to settle NPL with borrowers at the
  FSV (forced sale value) of the under-lying
  collateral.
• This step (taken out of desperation/ frustration)
  has had the desired results obviously!!!.
• Administrative insolvency and similar one size
  fits all solutions have the advantage of being
  fast-track.

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GROUND ZERO WHERE ARE WE??? (Contd)

• Final (hard) numbers relating to SBPs FSV
  scheme have been requested. However, as per
  preliminary figures, around Rs. 125 billion of
  NPL had been settled at the cost of Rs. 75
  billion in terms of write-offs (provisions used)
  a very low write-off efficiency ratio.
• The costs (quantitative and qualitative) of these
  positive outcomes are high. Some of these costs
  are as follows-
• 1. Admission of failure
• Periodic recourse to these one-time amnesty
  and incentive
• schemes is a de facto public admission that
  in the areas of
• insolvency, corporate rescue, etc., the
  legal system has effectively
• collapsed.

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GROUND ZERO WHERE ARE WE??? (Contd)

• 2. Heavy guzzler of provisions
• In the late 1990s, smart banks/ bankers were
  making aggressive
• one-shot settlements with borrowers at
  values ranging from P25
• to P50 - at a time when Pakistans
  economy was very weak. It
• is a pity that now (with high GNP growth
  rates) distressed assets
• are being settled at values as low as P-75
  to P-25!!!.
• 3. The problem with the FSV concept
• It is an arbitrary figure which assumes that
  all NPL is on a
• liquidation basis (i.e. not a going
  concern). The amount of
• provisions used (i.e., write-offs
  generated) could have been
• substantially reduced by using the concept
  of sustainable debt. The
• methodology for using this concept was
  available i.e., HBLs EDR
• (excess debt recovery) product/ scheme
  (P25) presented to the
• GoP in 1999.

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GROUND ZERO WHERE ARE WE??? (Contd)

• 4. The mechanics of determining FSV
• Under SBPs guidelines, FSV is determined by
  evaluators, an
• unregulated profession (capacity building
  issue). Enormous
• power has been granted to evaluators.
  Anecdotal evidence
• suggests that these powers have been abused/
  misused.
• 5. Sickness worthy of revival
• Not all companies are worth reviving e.g.,
  inefficient, obsolete
• technology, etc. In fact, owing to
  competitive disadvantages,
• sometimes entire industries can be
  considered to be unworthy
• e.g., textile products in North Asia, sugar
  in Pakistan, etc. Amnesty
• schemes (that are not based on financial
  data) cannot make such
• distinctions.

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GROUND ZERO WHERE ARE WE??? (Contd)

• 6. Amnesty schemes protect inefficient
  managements
• Very often the root cause of sickness is the
  management. In such
• cases, a change of management can convert
  sick entities into
• healthy companies.
• 7. Moral hazard
• Such schemes promote the default culture
  and have a cumulative
• effect that can last for decades.

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CORPORATE REHABILITATION ACT THE OPERATING
ENVIRONMENT

• By 2003, it had become clear that the hard
  approach towards the NPL problem was not working.
• The two recovery laws were being administered by
  incompetent specialized banking courts. Both
  these laws are conceptually unsound as they
  permit accrual on NPL (non-accrual loans).
• CIRC had failed to develop any appetite and/ or
  capacity for debt re-structuring and chose to act
  purely as an auction house. CIRC has had a very
  limited success in clearing up balance sheets of
  the financial institutions (World Bank Report
  2003). Fortunately, CIRC has a mandated expiry
  date. Any extension granted would defy logic and
  common sense.
• NAB had effectively abdicated the NPL field owing
  to its initial failures, inappropriate staffing
  and inherent defects in its law.

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CORPORATE REHABILITATION ACT THE OPERATING
ENVIRONMENT (Contd)

• CIRSU (Committee for the Rehabilitation of Sick
  Industrial Units) was created through a
  notification by the MoF in 2000. It has chosen to
  act as an arbitration window, and has not
  developed any capacity to undertake deep (i.e.,
  operational) restructuring. Typically a debt is
  re-scheduled (often cosmetically) and revival
  is declared. The MoF should actively consider its
  closure.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE

• We considered three alternative models, while
  drafting the CRA, namely-
• An empowered administrative body (the Indian
  model).
• Judicial administration (the English model).
• Chapter 11 (the American model).
• The need to have a system with elements of both
  re-organisation and liquidation was a key
  concern. Re-organisation without effective
  liquidation creates a very unbalanced insolvency
  system. If liquidation provisions are not
  credible, then bankruptcy law doesnt do its
  work if re-organisation provisions are not
  practicable, then companies are liquidated
  unnecessarily. Uncertainty results in either
  case.
• The merits of creditorin-possession models
  versus debtor-in-possession models were also
  debated. We opted for the latter, for
  value-maximization reasons.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE
(Contd)

• The lack of judicial expertise, the total absence
  of relevant professional bodies (e.g.,
  administrators, receivers, liquidators,
  evaluators, etc.,), and insolvency desires
  created by the GoPs amnesty schemes were viewed
  as key risks by us. Appropriate risk management
  measures have been built into the CRA. Several
  innovative ideas were developed by us after
  examining 10-12 non-OECD jurisdictions. The
  Mexican insolvency law (and related institutions/
  structures) were particularly useful.
• Administrative models. We have been down this
  road before (i.e., the H.U. Beg Committee) it
  does not work.
• In India, under the SICA (Sick Industrial
  Companies Act) of 1984, a Board of Industrial and
  Financial Restructuring (BIFR) was created.
  BIFRs decision-making processes proved to be
  more cumbersome (and slower) than the courts.
  SICA, BIFR and all related structures are being
  disbanded.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE
(Contd)

• To be effective, an insolvency process requires
  the pro-active participation of both the
  interested parties i.e., debtors and
  creditors.
• In the administrative model, this key feature is
  missing. A group of disinterested bureaucrats
  cannot be considered to be credible stake-holders
  in an insolvency process.
• The English model
• A widespread suspicion about the underlying
  motives of debtors led to consideration of the
  English Model, involving debtor-eviction. The
  perceived advantage was contested entry, which
  was seen as a method to remove the possibility of
  countless frivolous insolvency petitions. A
  further advantage was management by a judicial
  administrator who would also prepare the
  rehabilitation plan for the court.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE
(Contd)

• The key hurdle in adopting this model is
  Pakistans lack of competent administrators who
  could perform such functions under the law.
• Another hurdle was that a contested entry system
  would add an extra layer of litigation, causing
  unnecessary delays to the process.
• The Australian CVA (Corporate Voluntary
  Administration) was also looked at. CVA also has
  the same implementation issues as stated above.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE
(Contd)

• The American model (Chapter 11).
• We have adopted the American model with
  significant modifications. Our CRA has the
  following salient features-
• Entry into rehabilitation proceedings is a right.
  However, debtors must consider such a step
  carefully because of the provision for automatic
  conversion into liquidation in the event that no
  rehabilitation plan is approved. Various
  quantitative tests for entry were considered, but
  were discarded owing to the widespread use of
  cooked financial statements.
• The process is entirely stakeholder driven. Both
  the debtor and the creditor(s) can file plans.
• The entire process has been compressed with
  finite time-frames. For example, the debtor has a
  maximum of one month after entry into
  rehabilitation proceedings to file a plan. In
  fact, there are fairly stringent time-frames
  throughout the whole process.

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CORPORATE REHABILITATION ACT LEGAL ARCHITECTURE
(Contd)

• The American model (Chapter 11) Contd
• In Pakistan, taxes, levies and government dues
  enjoy substantial legal protection. Income tax,
  sales tax, and customs officers can re-open
  cases several fiscal years later. In fact,
  bankers have often engineered rehabilitation via
  a change of management or the induction of a new
  entrepreneur only to be thwarted by extortionist
  claims for back taxes. In the CRA, all such taxes
  and levies are classified as unsecured debts. The
  idea is to move some of the costs of the
  inevitable losses away from the banking system.
• Treatment of stakeholder rights and priorities.
  The current system of giving priority to
  un-secured creditors (e.g., state dues, taxes,
  wages, provincial levies, utility bills, etc.) is
  archaic and not sustainable and will have to be
  removed (IBRD/ UNICTRAL Insolvency Principle 16).
• In the United States, the cram-down feature is a
  threat designed to force consensus on a
  rehabilitation plan. In Pakistans context, we
  expect fairly active use of this provision at
  least, in the first few years before case law
  emerges and the whole system develops maturity.

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NON-SPECIALISED JUDGES WILL DELIVER POOR QUALITY
JUDGEMENTS HOW TO PLUG THE KNOWLEDGE GAP??

• War is too important a subject to be left to
  the generals.
• Winston Churchill, 1943
• Insolvency is too complex a subject to be left
  to the judges.
• Salman, 1999

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NON-SPECIALISED JUDGES WILL DELIVER POOR QUALITY
JUDGEMENTS HOW TO PLUG THE KNOWLEDGE GAP??
(Contd)

• The ideal legal structure would be specialized
  judges. Not possible in Pakistan.
• Likewise, a federal court structure would be
  preferable (e.g., Korea) as corporate groups
  operate in 2-3 different legal jurisdictions. Not
  possible.
• We had to ensure that two key ingredients are
  present (i,e., speed and predictability) inspite
  of the above limitations.
• We have achieved this by building into the CRA a
  multi-disciplinary vision - the judiciary is only
  one component.

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NON-SPECIALISED JUDGES WILL DELIVER POOR QUALITY
JUDGEMENTS HOW TO PLUG THE KNOWLEDGE GAP??
(Contd)

• We have recognised the limitations of Pakistans
  weak judicial capacity (where no specialised
  judges sit in the superior courts) by inserting a
  provision, which establishes a three-man Advisory
  Committee (comprising bankers, corporate finance
  specialists, etc.) to assist the insolvency
  judge/ court. This committee should be an
  excellent resource for judges that are unsure
  about the correct treatment of complex financial
  issues. Furthermore, they should be able to offer
  lucid advice in the likely event of several
  competing plans being submitted particularly
  when the new cram-down feature is being
  exercised.
• In reality, the Advisory Committee will be the
  tail that wags the dog.
• If appropriately selected, they will be the real
  decision-makers with the judge ratifying and
  sanctifying the decision. This concept is
  called pre-packaged insolvency it has been
  used in several jurisdictions to fast-track legal
  proceedings.
• On capacity-building issues, we have drawn
  extensively from Mexico (Insolvency Law of 2000)
  where several ground realities are similar to
  Pakistan.

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THE RISK MANAGER MUST GET OFF THE FENCE

• As stated earlier, the government is the ultimate
  risk manager.
• The vast majority of the comments received from
  MoF relate to costs.
• It is unfair to pose these questions to the
  author(s) of the CRA.
• I have tried to demonstrate that the current
  system and structures are not workable. They
  cannot be tweaked.
• The GoP must choose between two divergent paths.

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THE RISK MANAGER MUST GET OFF THE FENCE (Contd)

• Choice 1 to invest in a modern insolvency system
  by adopting the CRA and closing all other
  insolvency windows i.e., CIRC, CIRSU, NAB,
  etc.
• The cost is several billion rupees.
• Choice 2 no change.
• The cost is un-predictability plus billions of
  rupees spent on ad-hoc measures i.e., periodic
  financial sector re-capitalisation and corporate
  bail-out schemes.
• Whichever path is adopted, getting off the fence
  would be a useful starting point.